Long debated and long-awaited, the Volcker rule is being hailed as the 21st-century equivalent of the Depression-era legislation known as the Glass-Steagall Act.
For proponents of the rule rolled out Tuesday, it imposes a needed ban on proprietary-trading strategies by banks that deserve the lion’s share of the blame for the recent financial crisis. They may well be right. But they should consider this: Eighty years ago, financial reformers believed they had found the culprit responsible for the crash and banking crisis that inaugurated the Great Depression. And they were wrong.
The reformers of the 1930s gave us Glass-Steagall, legislation born of a staggering collapse in the nation’s banking system that began shortly after the stock market crashed in 1929. As thousands of banks went under, much of the blame came to rest on commercial banks that established “affiliates” that acted like investment banks, buying and selling securities.
Conventional wisdom soon held that these affiliates made risky bets that toppled the more staid, conservative commercial banks that stood behind them. In response, reformers such as Senator Carter Glass argued for a separation of commercial and investment banking. Banks could do one or the other -- not both.
Glass got a much-needed boost for the legislation when the Senate held hearings into the causes of the financial crisis in 1933. Ferdinand Pecora, the chief counsel of the Committee on Banking and Currency, presided over the inquiries. Pecora summoned bank presidents, and with ruthless questioning, he quickly extracted evidence of malfeasance, never mind conflicts of interest, among the different divisions of some of the nation’s most prominent banks. This confirmed many people’s suspicions, and reformers concluded that banks should be split up and confined to either commercial or investment functions.
Glass-Steagall, named for Glass and his House counterpart, Henry Steagall, did precisely that. It created a firewall between commercial and investment banking that remained in place for almost half a century.
But was it justified? In 1986, the economist Eugene N. White published a seminal article that challenged prevailing assumptions. Between 1930 and 1933, about 26.3 percent of U.S. national banks failed. By taking a close look at the numbers, White found that national banks with a securities affiliate or other investment-bank operations were less likely to fail, with only 6 percent to 8 percent going under. In fact, commercial banks that steered clear of dealing in securities were far more fragile and likely to collapse. Most banks that failed were on Main Street, not Wall Street.
White also found evidence that there was no basis for the notion of harmful conflicts of interest between the commercial banks and their securities affiliates. This was later corroborated in an article by the economists Randall Kroszner and Raghuram Rajan, who found that securities offerings underwritten via affiliates at commercial banks were superior to those underwritten by conventional, independent investment banks. Far from defrauding investors, as everyone suspected, the securities affiliates had, in the aggregate, delivered better returns, especially for lower-grade securities.
Nevertheless, many other sensible people cling to the idea that mixing commercial and investment banking was a terrible idea. In 1986, none other than Paul Volcker himself would testify before Congress that the Pecora hearings had revealed that “bank affiliates had underwritten and sold unsound and speculative securities, published deliberately misleading prospectuses, manipulated the price of particular securities ... engaged in insider lending practices and unsound transactions with affiliates.”
But even if we now know that Glass-Steagall was designed to fix the wrong problem, that doesn’t mean it was a bad idea. As the economic historian Peter Temin has observed, the larger regulatory framework of that legislation “provided a setting in which banks were stable for over a half century during a great expansion of the American economy.”
In other words, Glass-Steagall failed to fix problems of the past, but it may have unwittingly anticipated problems in the future.
And therein lies a lesson about post-crisis regulation. In the chaos of a financial crisis, never mind its aftermath, it’s easy to jump the gun and impose regulations that satisfy the urge to “do something” yet achieve little to address the underlying causes of the disaster. The resulting regulation can deliver benefits, or it can be counterproductive. Or both. But neither outcome is dependent on a correct reading of the causes of the crisis.
This will probably be true of the Volcker rule, too: It will be judged not on whether it was a logical response to what happened, but whether it ushers in a new era of financial stability. On that question, we may have to wait years for a clear answer.
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